Question 1

Cranberry Corp. has two divisions of equal size: a computer manufacturing division and a data processing division. Its CFO believes that stand-alone data processor companies typically have a WACC of 8%, while stand-alone computer manufacturers typically have a 12% WACC. He also believes that the data processing and manufacturing divisions have the same risk as their typical peers. Consequently, he estimates that the composite, or corporate, WACC is 10%. A consultant has suggested using an 8% hurdle rate for the data processing division and a 12% hurdle rate for the manufacturing division. However, the CFO disagrees, and he has assigned a 10% WACC to all projects in both divisions. Which of the following statements is CORRECT?

Accepted Answer

A)   While the decision to use just one WACC will result in its accepting more projects in the manufacturing division and fewer projects in its data processing division than if it followed the consultant's recommendation, this should not affect the firm's intrinsic value.
B)   The decision not to adjust for risk means, in effect, that it is favoring the data processing division. Therefore, that division is likely to become a larger part of the consolidated company over time.
C)   The decision not to adjust for risk means that the company will accept too many projects in the manufacturing division and too few in the data processing division. This will lead to a reduction in the firm's intrinsic value over time.
D)   The decision not to risk-adjust means that the company will accept too many projects in the data processing business and too few projects in the manufacturing business. This will lead to a reduction in its intrinsic value over time.
E)   The decision not to risk adjust means that the company will accept too many projects in the manufacturing business and too few projects in the data processing business. This may affect the firm's capital structure but it will not affect its intrinsic value. C

Question 2

Safeco Company and Risco Inc are identical in size and capital structure. However, the riskiness of their assets and cash flows are somewhat different, resulting in Safeco having a WACC of 10% and Risco a WACC of 12%. Safeco is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Safeco project. Risco is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical Risco project.
Now assume that the two companies merge and form a new company, Safeco/Risco Inc. Moreover, the new company's market risk is an average of the pre-merger companies' market risks, and the merger has no impact on either the cash flows or the risks of Projects X and Y. Which of the following statements is CORRECT?

Accepted Answer

A)   If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time.
B)   If evaluated using the correct post-merger WACC, Project X would have a negative NPV.
C)   After the merger, Safeco/Risco would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y.
D)   Safeco/Risco's WACC, as a result of the merger, would be 10%.
E)   After the merger, Safeco/Risco should select Project Y but reject Project X. If the firm does this, its corporate WACC will fall to 10.5%. A

Question 3

If a firm is privately owned, and its stock is not traded in public markets, then we cannot measure its beta for use in the CAPM model, we cannot observe its stock price for use in the DCF model, and we don't know what the risk premium is for use in the bond-yield-plus-risk-premium method. All this makes it especially difficult to estimate the cost of equity for a private company.

Accepted Answer

A) True 
 B)False  True

Question 4

To help finance a major expansion, Castro Chemical Company sold a noncallable bond several years ago that now has 20 years to maturity. This bond has a 9.25% annual coupon, paid semiannually, sells at a price of $1,075, and has a par value of $1,000. If the firm's tax rate is 40%, what is the component cost of debt for use in the WACC calculation?

Accepted Answer

A)   4.35%
B)   4.58%
C)   4.83%
D)   5.08%
E)   5.33%

Question 5

The cost of external equity capital raised by issuing new common stock (re) is defined as follows, in words: "The cost of external equity equals the cost of equity capital from retaining earnings (rs), divided by one minus the percentage flotation cost required to sell the new stock, (1 - F)."

Accepted Answer

A) True 
 B)False

Question 6

The cost of debt, rd, is normally less than rs, so rd(1 - T) will normally be much less than rs. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than rd(1 - T).

Accepted Answer

A) True 
 B)False

Question 7

Eakins Inc.'s common stock currently sells for $45.00 per share, the company expects to earn $2.75 per share during the current year, its expected payout ratio is 70%, and its expected constant growth rate is 6.00%. New stock can be sold to the public at the current price, but a flotation cost of 8% would be incurred. By how much would the cost of new stock exceed the cost of retained earnings?

Accepted Answer

A)   0.09%
B)   0.19%
C)   0.37%
D)   0.56%
E)   0.84%

Question 8

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the DCF method is widely used in practice.

Accepted Answer

A) True 
 B)False

Question 9

The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, are not deductable by the issuing firm.

Accepted Answer

A) True 
 B)False

Question 10

Trahan Lumber Company hired you to help estimate its cost of capital. You obtained the following data: D1 = $1.25; P0 = $27.50; g = 5.00% (constant); and F = 6.00%. What is the cost of equity raised by selling new common stock?

Accepted Answer

A)   9.06%
B)   9.44%
C)   9.84%
D)   10.23%
E)   10.64%

Question 11

Which of the following statements is CORRECT?

Accepted Answer

A)   The discounted cash flow method of estimating the cost of equity cannot be used unless the growth rate, g, is expected to be constant forever.
B)   If the calculated beta underestimates the firm's true investment risk--i.e., if the forward-looking beta that investors think exists exceeds the historical beta--then the CAPM method based on the historical beta will produce an estimate of rs and thus WACC that is too high.
C)   Beta measures market risk, which is, theoretically, the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. This is true even if not all of the firm's stockholders are well diversified.
D)   An advantage shared by both the DCF and CAPM methods when they are used to estimate the cost of equity is that they are both "objective" as opposed to "subjective," hence little or no judgment is required.
E)   The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-risk-premium approach.

Question 12

Schalheim Sisters Inc. has always paid out all of its earnings as dividends, hence the firm has no retained earnings. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC?

Accepted Answer

A)   The market risk premium declines.
B)   The flotation costs associated with issuing new common stock increase.
C)   The company's beta increases.
D)   Expected inflation increases.
E)   The flotation costs associated with issuing preferred stock increase.

Question 13

Assume that you are a consultant to Broske Inc., and you have been provided with the following data: D1 = $0.67; P0 = $27.50; and g = 8.00% (constant). What is the cost of equity from retained earnings based on the DCF approach?

Accepted Answer

A)   9.42%
B)   9.91%
C)   10.44%
D)   10.96%
E)   11.51%

Question 14

When working with the CAPM, which of the following factors can be determined with the most precision?

Accepted Answer

A)   The market risk premium (RPM) .
B)   The beta coefficient, bi, of a relatively safe stock.
C)   The most appropriate risk-free rate, rRF.
D)   The expected rate of return on the market, rM.
E)   The beta coefficient of "the market," which is the same as the beta of an average stock.

Question 15

Assume that you are on the financial staff of Vanderheiden Inc., and you have collected the following data: The yield on the company's outstanding bonds is 7.75%, its tax rate is 40%, the next expected dividend is $0.65 a share, the dividend is expected to grow at a constant rate of 6.00% a year, the price of the stock is $15.00 per share, the flotation cost for selling new shares is F = 10%, and the target capital structure is 45% debt and 55% common equity. What is the firm's WACC, assuming it must issue new stock to finance its capital budget?

Accepted Answer

A)   6.89%
B)   7.26%
C)   7.64%
D)   8.04%
E)   8.44%

Question 16

When estimating the cost of equity by use of the CAPM, three potential problems are (1) whether to use long-term or short-term rates for rRF, (2) whether or not the historical beta is the beta that investors use when evaluating the stock, and (3) how to measure the market risk premium, RPM. These problems leave us unsure of the true value of rs.

Accepted Answer

A) True 
 B)False

Question 17

For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity.

Accepted Answer

A) True 
 B)False

Question 18

"Capital" is sometimes defined as funds supplied to a firm by investors.

Accepted Answer

A) True 
 B)False

Question 19

The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock.

Accepted Answer

A) True 
 B)False

Question 20

The MacMillen Company has equal amounts of low-risk, average-risk, and high-risk projects. The firm's overall WACC is 12%. The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If the CEO's position is accepted, what is likely to happen over time?

Accepted Answer

A)   The company will take on too many high-risk projects and reject too many low-risk projects.
B)   The company will take on too many low-risk projects and reject too many high-risk projects.
C)   Things will generally even out over time, and, therefore, the firm's risk should remain constant over time.
D)   The company's overall WACC should decrease over time because its stock price should be increasing.
E)   The CEO's recommendation would maximize the firm's intrinsic value.

Exam 10: Cost of Capital

The cost of external equity capital raised by issuing new common stock (re) is defined as follows, in words: "The cost of external equity equals the cost of equity capital from retaining earnings (rs), divided by one minus the percentage flotation cost required to sell the new stock, (1 - F)."

The cost of debt, rd, is normally less than rs, so rd(1 - T) will normally be much less than rs. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than rd(1 - T).

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the DCF method is widely used in practice.

The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, are not deductable by the issuing firm.

Trahan Lumber Company hired you to help estimate its cost of capital. You obtained the following data: D1 = $1.25; P0 = $27.50; g = 5.00% (constant) ; and F = 6.00%. What is the cost of equity raised by selling new common stock?

Which of the following statements is CORRECT?

Assume that you are a consultant to Broske Inc., and you have been provided with the following data: D1 = $0.67; P0 = $27.50; and g = 8.00% (constant) . What is the cost of equity from retained earnings based on the DCF approach?

When working with the CAPM, which of the following factors can be determined with the most precision?

For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity.

"Capital" is sometimes defined as funds supplied to a firm by investors.

The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock.